FOREIGN EXCHANGE

SATVIK, VRISSHIN, MANYAA

 INTRODUCTION

 Forex, or foreign exchange, can be explained as a network of buyers and sellers, who transfer currency between
each other at an agreed price. It is the means by which individuals, companies and central banks convert one
currency into another
 The global Foreign exchange market is the largest market in the world as measured by the daily turnover with
more than US$5 trillion a day eclipsing the combined turnover of the world’s stock and bond markets.

What is Forex?
 Forex (in simple terms, currency) is also called the foreign exchange, FX or currency trading. It is a
decentralized global market where all the world’s currencies trade with each other. It is the largest liquid market
in the world.
 The liquidity (more buyers and sellers) and competitive pricing (the spread is very small between bid and ask
price) available in this marked are great. With the irregularity in the performance in other markets, the growth of
forex trading, investing and management is in upward trajectory.
 WHY TRADE FOREX?
Forex market never sleeps
 The Forex market works 24 hours and 5-1/2 days a week. Because governments, corporates and private individual who require currency exchange
services are spread around the world, so trading on the forex market never stops. Activity on the forex market follows the sun around the world, so
right from the Monday morning opening in Australia to the afternoon close in New York. At any point of the day you can find an active pair to trade.

High liquidity in Forex

 The FX market is the most liquid market in the world, meaning there are a large number of buyers and sellers looking to make a trade at any given
time. Each day, over $5 trillion dollars of currency is converted by individuals, companies and banks – and the vast majority of this activity is
intended to generate a profit. High liquidity means a trader can trade with any type of currency. The buyers and sellers across the world accept
different types of currencies

Leverage
 Leverage is the mechanism by which a trader can take position much larger than the initial investment. Leverage is one more reason why you should
trade in forex. Few currency traders realize the advantage of financial leverage available to them.
 High leverage allows a trader with small investment to trade higher volumes of currencies and thus provide the opportunity to make significant profits
from the small movement in the market. However, if the market is against your assumption, you might lose significant amount too. 

Low transaction cost

 Most forex accounts trade with little or no commission and there is no exchange or data license fees. Generally, the retail transaction fee (the bid/ask
spread) is typically less than 0.1% under normal market conditions. With larger dealers (where volumes are huge), the spread could be as low as
0.05%.
 NATURE OF FOREX MARKETS
The foreign exchange market is the place where money denominated in one currency is bought and sold with money
denominated in another currency. It is the largest financial market in the world with prices moving and currencies trading
somewhere every hour of every business day.
1. Market Transparency
 Trader in the foreign exchange market has full access to all market data and information. They can easily monitor
different countries’ currencies price fluctuations through real-time portfolio and account tracking without the need of a
broker. All this information helps in making better trading decisions and control over investments.
2. Dollar is extensively traded currency
 The dollar is the most dominant currency in the foreign exchange market. This currency is paired with every country’s
currency being traded in the forex market. In a major proportion of transactions every day, the dollar is one of the two
currencies being traded.
3. Most Dynamic market
 The foreign exchange market is a dynamic market. In these markets, currency values change every second and hour.
These values change in accordance with changing forces of demand and supply which also helps in determining the
exchange rates. Due to its fast changing character, this market is termed perfect to trade in.
 TYPES OF FOREX MARKETS

There are three different types of forex market: 

1. Spot forex market: the physical exchange of a currency pair, which takes place at the exact point
the trade is settled – ie ‘on the spot’ – or within a short period of time. This allows the traders open
to the volatility of the currency market, which can raise or lower the price, between the agreement
and the trade.  No security deposit is required as no money changes hands when the deal is signed. 
2. Forward forex market: a contract is agreed to buy or sell a set amount of a currency at a
specified price, to be settled at a set date in the future or within a range of future dates
 Forward contracting is very valuable in hedging and speculation. a bread factory want to buy
bread forward in order to assist production planning without the risk of price fluctuations. There
are speculators, who based on their knowledge or information forecast an increase in price. They
then go long (buy) on the forward market instead of the cash market. Now this speculator would
go long on the forward market, wait for the price to rise and then sell it at higher prices; thereby,
making a profit.
 TYPES OF FOREX MARKETS

(cont.) The basic problem is that there is a lot of flexibility and generality. The forward market is like two
persons dealing with a real estate contract (two parties involved - the buyer and the seller) against each
other. The larger the time period over which the forward contract is open, the larger are the potential price
movements, and hence the larger is the counter-party risk involved. 

 3. Future forex market: a contract is agreed to buy or sell a set amount of a given currency at a set price
and date in the future. Unlike forwards, a futures contract is legally binding. There is no counterparty
risk involved as exchanges have clearing corporation, which becomes counterparty to both sides of each
transaction and guarantees the trade. Future market is highly liquid as compared to forward markets as
unlimited persons can enter into the same trade
FUNCTIONS OF FOREX MARKET

Transfer Function: The basic and the most visible function of foreign exchange market is the transfer of funds (foreign
currency) from one country to another for the settlement of payments. It basically includes the conversion of one
currency to another, wherein the role of FOREX is to transfer the purchasing power from one country to another. For
example, if an Indian exporter imports goods from the United States and the payment is to be made in dollars, FOREX
trading online would facilitate the conversion of the rupee to the dollar. 

Credit Function: FOREX provides a short-term credit to the importers so as to facilitate the smooth flow of goods
and services from country to country. An importer can use credit to finance the foreign purchases. Such as an Indian
company wants to purchase the machinery from the USA, can pay for the purchase by issuing a bill of exchange in the
foreign exchange market, essentially with a three-month maturity.

Hedging Function: The third function of a foreign exchange market is to hedge foreign exchange risks. The parties to
the foreign exchange are often afraid of the fluctuations in the exchange rates, i.e., the price of one currency in terms of
another. The change in the exchange rate may result in a gain or loss to the party concerned.
 PARTICIPANTS

 Structure of the forex market is rather unique because major volumes of transactions are done in Over-The-Counter
(OTC) market which is independent of any centralized system (exchange) as in the case of stock markets.
 Over-the-counter (OTC) is the trading of securities between two counterparties executed outside of formal exchanges
and without the supervision of an exchange regulator. It done in over-the-counter markets (a decentralized place with no
physical location), through dealer networks.
  The participants in this market are −

Central Banks
Commercial and Investment banks
Corporations for international business transactions
Hedge funds
Speculators
Pension and mutual funds
Forex brokers
 Corporations
Fund Managers, Hedge Funds, and Sovereign •Similar to investment managers and hedge funds,
Wealth Funds corporations deal with banks. More giant
corporations often deal with the larger banks
•This category is not involved in defining the
directly.
prices or controlling them. They are basically
•Then, smaller businesses will work with smaller
transnational and home-country’s money
banks. Forex brokers are corporations and belong in
managers. They may deal in hundreds of
this niche in the chain of dealing. Plenty of
millions of dollars, as their portfolios of corporations are multinational or at least interested
investment funds are often quite large. in international trade.
•These participants have investment charters •And even if they do not, their profits are open to the
and obligations to their investors. The major risk of fluctuations in currency exchange rates.
aim of hedge funds is to make profits and grow
their portfolios. They want to achieve absolute
returns from the Forex market and dilute their
risk. Liquidity, leverage, and low cost of
creating an investment environment are the
advantages of hedge funds.
 INTERBANK MARKET

 The interbank market is a network of international banks operating in financial centres around the world.
Currency trading today is largely concentrated in the hands of about a dozen major global financial firms,
such as UBS, Citibank, JPMorgan Chase etc.
 The goal of the Interbank Market is to provide liquidity to other market participants and garner information
from the flow of money.  Large financial institutions can trade directly with each other or through
electronic fx interbank platforms. The players in the interbank market are commercial banks, investment
banks, central banks, hedge funds and trading companies
 These banks maintain trading operations to facilitate speculation for their own accounts, called proprietary
trading (or prop trading for short), and to provide currency trading services for their customers. Banks’
customers can range from corporations and government agencies to hedge funds and wealthy private
individuals.
FOREX RISK MANAGEMENT

 Forex risk management comprises individual actions that allow traders to protect against the downside
of a trade. More risk means higher chance of sizeable returns – but also a greater chance of significant
losses. Therefore, being able to manage the levels of risk to minimize loss, while maximizing gains, is
a key skill for any trader to have.
 Risk management can include establishing the correct position size, setting stop losses, and 
controlling emotions when entering and exiting positions. Implemented well, these measures can prove
to be the difference between profitable trading and losing it all.
WHAT ARE THE RISKS OF FOREX MANAGEMENT?

 Currency risk is the risk associated with the fluctuation of currency prices, making it more or less
expensive to buy foreign assets
 Interest rate risk is the risk related to the sudden increase or decrease of interest rates, which affects 
volatility. Interest rate changes affect FX prices because the level of spending and investment across an
economy will increase or decrease, depending on the direction of the rate change
 Liquidity risk is the risk that you can’t buy or sell an asset quickly enough to prevent a loss. Even
though forex is a highly liquid market, there can be periods of illiquidity – depending on the currency
and government policies around foreign exchange
 Leverage risk is the risk of magnified losses when trading on margin. Because the initial outlay is
smaller than the value of the FX trade, it’s easy to forget the amount of capital you are putting at risk
GLOBAL FOREIGN
EXCHANGE

 The Global Foreign Exchange market is said to

be the largest, fastest growing and most liquid
market in the world.
 It is a virtual plane linking networks of banks,
Forex brokers and dealers.
 Trading is done throughout the day via SWIFT
(Society for Worldwide International Financial
Telecommunications) which is a satellite basede
communications system.
ISO 4217:2015

 The International Organization for Standardization (ISO) has established ‘three-letter alphabetic codes’ that
represent currencies over the world.
 Each three-letter code also has a corresponding three letter numeric code for regions that do not use Latin Scripts.
 The governing document for currencies is known as “ISO 4217:2015”.
 For example : Indian Rupee – INR; South African Rand – ZAR
MOST TRADED CURRENCIES IN THE WORLD

 United States Dollar (USD)

 Euro (EUR)
 Japanese Yen (JPY)
 Pound Sterling (GBP)
 Australian Dollar (AUD)
 Canadian Dollar (CAD)
 Swiss Franc (CHF)
 Chinese Yuan (CNY)
 Swedish Krona (SEK)
 New Zealand Dollar (NZD)
 Hong Kong Dollar (HKD)
STRUCTURE
OF THE
FOREIGN
EXCHANGE
MARKET
• The bottom most category consists of
the actual buyers and sellers of foreign
currencies. They approach commercial
banks to buy this currency.
• Commercial Banks play the role of
Central Banks
market makers and help balance the
demand and supply of currencies.
(Executes the function of a ‘clearing
house’). They buy currency from Brokers
brokers and in turn sell it to the
buyers.
• Foreign Exchange Brokers link buyers
and commercial banks to Central
Banks. They make money through Commercial Banks
commissions and provide vital
information related the market.
• The Central bank of any country is the
”Custodian of Foreign Exchange of
the Country”. They control and
Exporters, Importers, Tourists,
regulate the Foreign exchange market. Investors and Immigrants
TWO PARTS OF
FEM
 Inter-Bank

Wholesale

Central bank
Foreign Exchange
Market
Banks and currency
changers (Currencies,
Retail
bank notes and
cheques)
CURRENCY CONVERTIBILITY

 Shows liquidity of a nation’s currency with regards to exchanging with other global currencies.
 Quite simply means converting one currency to another on the forex market.
 Highly convertible currencies such as the Japanese yen (JPY), United States Dollar (USD) and Pound Sterling
(GBP) are easily exchangeable and are preferred by investors.
 Blocked Currencies are those which are not eligible for conversion to a foreign currency such as Cuban Peso
(CUP) and North Korea Won (KPW).
CURRENCY PAIRS

 A ‘Currency Pair’ is a quotation of two different currencies with the value of one being quoted against the other.
(XXX/YYY is how a currency pair is recognized)
 The first listed currency (in the above scenario, XXX) is called the “Base Currency” and the second listed
currency (in the above scenario, YYY) is known as the “Quote Currency”.
 The Base Currency is the currency that is BOUGHT in exchange for the Quote Currency.
 For example :
 Currency pair – EUR/USD

A quoted price of 1.15 means 1 Euro is exchanged for 1.15 American dollar
 Top Currency Pairs in 2019 VS. Top Currency Pairs in 2021

Base currency Quote Currency Base currency Quote Currency

Euro (EUR) United States Dollar (USD) Euro (EUR) United States Dollar (USD)
United States dollar (USD) Japanese Yen (JPY) Pound Sterling (GBP) United States Dollar (USD)
Pound Sterling (GBP) United States Dollar (USD) United States dollar (USD) Japanese Yen (JPY)
Australian Dollar (AUD) United States Dollar (USD) Australian Dollar (AUD) United States Dollar (USD)
United States Dollar (USD) Canadian Dollar (CAD) Euro (EUR) Pound Sterling (GBP)
United States Dollar (USD) Chinese Yuan (CNY) United States Dollar (USD) Canadian Dollar (CAD)
United States Dollar (USD) Swiss Franc (CHF) United States Dollar (USD) Swiss Franc (CHF)
Unites States Dollar (USD) Hong Kong Dollar (HKD) New Zealand Dollar (NZD) Swiss Franc (CFH)
Euro (EUR) Pound Sterling (GBP) United States Dollar (USD) Chinese Yuan (CNY)
United States Dollar (USD) South Korean Won (KRW) United States Dollar (USD) Hong Kong Dollar (HKD)
EXCHANGE RATES

 An exchange rate is the price of one country’s currency in terms of another country’s
currency / the rate at which one country’s currency would be exchanged for another
country’s currency.
DIRECT AND INDIRECT QUOTATION

 Direct quote – When 1 unit of the foreign currency is expressed in terms of local
currency i.e $1 = Rs 72

 Indirect quote – When 1 unit of local currency is expressed in terms of foreign

currency i.e Rs 1 = $ 1/72
TWO-WAY QUOTATION

 Indicates 2 sets of different exchange rate known as bid rate and ask rate
 Bid rate – rate at which bank will buy the currency from the customer
 Ask rate – rate at which the bank will sell the currency to the customer.
 Example : $1 = Rs 72 – Rs 73

Rs 72 – bid rate ; Rs 73 – ask rate

 Spread = ask rate – bid rate
CONVERSION OF TWO-WAY QUOTES

 Inverse of bid rate in a direct quote will become ask rate of indirect quote
 Inverse of ask rate in a direct quote will become bid rate of indirect quote

 $1 = Rs 72 – Rs 73

 Rs 1 = $1/73 - $ 1/72
 $1/73-bid rate ; $1/72 – ask rate
SPOT RATES AND FORWARD RATES

 Spot rate – the current exchange rate at which a currency can be bought or sold

 Forward rate – it is the exchange rate at which the bank agrees to exchange currency
in a specified future date with the customer.
 CROSS-CURRENCY RATES

 Most exchange rate quotations are against the dollar. However, in certain instances the exchange rate
between two non dollar currency may be needed.

 Formula : - Value of 1 unit of currency A in units of currency B = Value of currency A in $/ Value of

currency B in $

 Example : £1 = $1.35 , Rs 1 = $0.013

Value of 1 £ in terms of Rs = 1.35/0.013 = 103.85

REAL EXCHANGE RATE AND NOMINAL EXCHANGE RATE

 Nominal exchange rate – The rate at which one currency can be exchanged for another currency
 Real exchange rate – It is the purchasing power of a currency relative to another currency. It is the nominal
exchange rate adjusted for differences in price levels in the two countries
 RER = NER X Domestic price/Foreign price

 Example :
NER = $1 = Rs 70 ; $2 for basket ; Rs 100 for basket
RER = 70 X 2 /100 = 1.4
1.4 Indian basket / US basket
REER AND NEER

 NEER (Nominal effective exchange rate) – weighted average of the bilateral nominal exchange rates of
the home countries against a few selected foreign currencies

 REER(Real effective exchange rate) – It is NEER adjusted for inflation

 They are used to obtain a summary of the changes in exchange rate against other major currencies
 Formula
APPRECIATION AND DEPRECIATION

 Appreciation – when the value of one currency increased relative to the value of another currency
 Depreciation – when the value of one currency decrease relative to the value of another currency

 Example:

$1 = Rs 72 to $1 = Rs 76 ( Rs 1 = $1/72 to Rs 1 = $1/76)

 INR depreciates and USD appreciates

 APPRECIATION AND DEPRECIATION

 Rate of appreciation:

= (F-S)/S X 100
= (76-72)/72 X 100 = 5.56%

 Rate of depreciation:

Method 1
= (1/76 – 1/72 ) / 1/72 X 100 = - 5.26%
Method 2
= (S-F)/F X 100
= ( 72-76)/76 X 100 = -5.26%
 FACTORS WHICH CAUSE APPRECIATION/DEPRECIATION

 Foreign demand for exports

 Domestic demand for imports
 Relative interest rate changes
 Relative rates of inflation
 Foreign investment
 Use of foreign currency reserves
 Change in income
 Speculation
EXCHANGE-RATE SYSTEMS

 Free-floating exchange rate system

 Fixed exchange rate system

 Pegged exchange rate system

FREE FLOATING EXCHANGE RATE SYSTEM

 Exchange rates are determined by forces of demand

and supply without intervention from government.
 The point where quantity of a currency demanded
equals the quantity supplied is the equilibrium
exchange rate
 FREE FLOATING EXCHANGE RATE
CHANGES

 Changes in demand and supply of a particular currency could lead to

appreciation and depreciation.
 A) If demand for dollar increases, the demand curve has a rightward
shift from D1 to D2. The dollar appreciates against the euros as the new
equilibrium is higher than original. ( $1= €0.67 to $1 = € 0.90)
 B) If supply of the euros increases, supply curve increases from S1 to S2
which leads to the euro depreciating against the dollar .
(€1 = $1.5 to €1 = $1.11)
FIXED-EXCHANGE RATE SYSTEM

 Exchange rates are fixed by the central banks of each country and aren’t permitted to change according
to market forces

 Maintaining the exchange rate requires constant intervention from the central bank and the government
which takes place through buying and selling currencies.

 If the fixed rate can’t be maintained, they are devalued or revalued.

 Devaluation – Decreasing the fixed exchange rate value
 Revaluation - Increasing the fixed exchange rate values
PEGGED EXCHANGE RATE SYSTEM

 Pegging exchange rates - A number of developing

countries peg their currencies to the US dollar, and
float together with it.
 The pegged currency is allowed to fluctuate only
within a narrow range above and below a target
exchange rate relative to the dollar, so that if the
actual exchange rate hits the upper or lower limit of
the range, the central bank intervenes to keep it
within the limits
OVERVALUED AND UNDERVALUED CURRENCY

 An overvalued currency is one that has a value that is too high relative to its
equilibrium free market value

 An undervalued currency is one whose value is too low relative to its equilibrium free
market value